Government Bubble Targeted with S&P Outlook

Apr. 19, 2011 3:12 PM ET

Washington has been placed on notice that it’s reckless spending and unfathomable fiscal debt is not immune to the censure of Wall Street.

To recap, Standard and Poor’s issued a press release yesterday announcing that it had cut the United States outlook: “The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years."

The markets reacted violently. Europe quickly dropped an additional percent, the Dow Jones Industrial Average opened down over one hundred points, and the gold price took off again, continuing its assault on $1,500 (reaching an all-time high of $1,498.60). Asset prices were extremely volatile during the first hour of trading, with currencies and commodity prices getting whipsawed.

On the one hand, the news doesn’t particularly matter; on the other, it is the only market news that matters.

The typical reaction from pundits was one of confusion: "The whole thing makes no sense to me," said Aaron Gurwitz, chief investment officer at Barclays Wealth in New York. "I can't tell a consistent story that explains all of these facts. My working hypothesis is this whole thing is ephemeral—people were looking for a reason to sell stocks today."

On the surface, I tend to agree with Mr. Gurwitz. The “press release” was really a non-event, especially considering the recent stream of legitimate “black swan” events (i.e. Japan’s tsunami) to which the markets have been largely impervious, even downright bullish. It is no secret that America’s financial situation has been deteriorating, or that Helicopter Ben has been experimenting more like Miley Cyrus than a conservative risk-averse central banker. Do investors really need a rating agency – an agency that has lost much of its credibility over the last several years - to inform them that America “may” be in a dire financial situation “within two years”? Hardly. The markets seemed predisposed to a sell off, and it was used as an excuse for many investors to pull the bid from the market.

However, on a philosophical level, it was a public relations blow to Washington and its fiscal irresponsibility, as well as an overt warning to all about the nation’s current debt crisis. The government’s initiative to transfer risk from the private sector to the public sector has created an all-encompassing bubble. I refer to this new bubble as the government bubble, the last of all major market bubbles. The overvaluation in asset prices is essentially a mispricing of risk. Like the equity bubble and the private debt bubble preceding the current government debt crisis, risk has been mispriced because of the Pavlovian response that government debt carries no risk. This response distorts the price of every other asset.

Practically, the government bubble implies that government agencies will continue to expand to the inevitable point that the country can no longer afford the federalization of the private sector and the socialization of risk. The S&P downgrade portends this fatal scenario and alerts investors to the mispricing of equities.

Since World War II, debt issued by the United States has been consider the triple-A above all triple-As. Wall St. uses US government debt yields as the “risk-free rate” for their valuation models when pricing assets. Even an otherwise “simple” mention that the outlook has been downgraded is a warning to investors about the potential for erroneous underlying assumptions.

While the S&P’s press release was in reality a non-event, its implication is highly relevant. The government is the last entity supporting everything below it. When the government bubble inevitably pops, the mispricing of risk will have a profound impact on asset prices regardless where these assets are in the capital structure.